Chapter 2. Global Cycles: Toward a Better Understanding
- Ayhan Kose, and Marco Terrones
- Published Date:
- December 2015
The U.S. baseball season culminates in a championship called the World Series, reflecting a time when the United States was the world when it came to baseball. Likewise, in the 1960s, a recession in the United States could just as well have been called a global recession. The United States accounted for a large share of world output, and cyclical activity in much of the rest of the world was dependent on U.S. conditions. What constitutes a global recession today? What is a global recovery? And what really happens during these episodes? This chapter introduces the conceptual framework we use to study these questions, explains how the rise of emerging market economies changed the global business cycle, and presents a road map for our journey toward a better understanding of global recessions and recoveries.
Fundamental Questions in Search of Answers
The depth and breadth of the worldwide recession associated with the 2007–09 financial crisis fueled intensive debate about global business cycles, and the ensuing recovery has added a new twist to these discussions. Three fundamental questions have anchored the debates: What is a global recession? What do we mean by a global recovery? And what really happens during these episodes? Although these issues have taken center stage, our understanding of them is surprisingly limited, primarily reflecting widespread confusion about the very definitions of the underlying concepts.
What is behind this confusion? A recession, by definition, implies a contraction in national gross domestic product (GDP).1 But the global economy rarely contracts because countries that experience recessions seldom do so in a way that is synchronized enough to translate into an outright decline in world GDP. This difficulty in describing a global recession, in turn, makes it challenging to concretely define a global recovery. Although there are simple rules of thumb to describe a national recession, such as two consecutive quarters of decline in national output, it is not easy to map such rules in a global context. For example, it is difficult to create quarterly GDP series for the world economy because most countries do not have reliable quarterly series over extended periods.
Why Do We Care?
Why is it important to have a good understanding of global recessions and recoveries? There are at least three main reasons.
First, as we extensively document in this book, global recessions are highly synchronized and costly events. When a country faces an isolated recession, this probably reflects domestic problems. The country can then employ a wide range of policy tools (if it has the policy space) to cope with a national recession. A global recession, however, often means that a number of countries are subject to a global shock or simultaneously suffer from various domestic economic problems. This might require international coordination of policies to dampen the impact of the global recession on national economies. A solid understanding of the main features of global recessions provides a wealth of lessons that can help mobilize such coordination efforts.
Second, understanding the nature of events surrounding global recessions is critical for effective monitoring of the evolution of national cycles. This is one of the major elements of economic surveillance at the national, regional, and global levels. As we discuss, there are complex linkages between global and national cycles, and the nature of these linkages is very much influenced by the state of the global cycle. For example, the impact of global growth on national growth is much greater during global recessions. Understanding such intricate linkages is vital if we are to better monitor economic activity.
Finally, a good grasp of the concepts of global recession and recovery is obviously necessary to develop analytical models of the global business cycle. Among their many purposes, such models can be used to study the sources of the global cycle, to study the nature of global shocks and their transmission mechanisms across borders, and to forecast fluctuations in world output.
What Does This Book Do?
We provide a comprehensive analysis of global recessions and recoveries. Specifically, we define global recessions and recoveries, document their main features, describe the events surrounding these episodes, put the latest global recession and ongoing recovery in perspective, and analyze the interactions between the global cycle and national business cycles.
We present a careful study of the evolution of global activity during global recessions and recoveries. Global recessions have been periods of collapse, with devastating human and social costs that lead to fears of economic apocalypse. A period of revival has followed each of them, but recovery has often been a long and painful process for some countries, including for many advanced economies during the last episode.
Global recessions have been periods of collapse, with devastating human and social costs that lead to fears of economic apocalypse.
Yet, our message is simple: collapse and revival are unavoidable phases of the global business cycle. This makes it all the more important to improve our understanding of global recessions and recoveries. We ultimately need to develop better policies in order to mitigate the costs associated with collapses while simultaneously accelerating revivals.
How Do We Do It?
A comprehensive book on global recessions and recoveries necessarily includes a healthy combination of the basic findings from academic research and insights from media articles describing the key events at the time of these episodes. The core of this book is based on a research program on global and national business cycles, and we also make extensive use of analytical findings from other branches of macroeconomic research, including research on fiscal and monetary policies, financial crises and cycles, labor markets, and uncertainty. For a better grasp of the key events surrounding global recessions and recoveries, we also conducted a detailed search of media articles around these episodes.
For readers interested in the background academic research, we provide short surveys of the relevant work in Focus boxes at the end of some chapters, and cite a number of related studies in notes at the end of the book. In addition, we provide a rich set of excerpts taken from the media articles published at the time of the episodes. These are particularly useful for readers interested in historical anecdotes and seeking a better sense of the prevailing public narrative.
Changing Nature of the Global Business Cycle
Before defining global recession and recovery, we need to define the global business cycle. Our definition is quite simple, drawing a parallel to the traditional characterization of a national business cycle2—global business cycles are a type of fluctuation found in worldwide economic activity: a global cycle consists of expansions occurring at about the same time in many indicators of global economic activity, followed by similarly global recessions and recoveries which merge into the expansion phase of the next global cycle.3 A Focus box at the end of this chapter briefly introduces the research on global business cycles.
Our understanding of the global business cycle has evolved over time: in the 1960s, it was sufficient to look at cyclical fluctuations in activity in advanced economies, the United States in particular, to have a good sense of it. These countries accounted for the lion’s share of world output, nearly 70 percent in the 1960s. Moreover, cyclical activity in much of the rest of the world was largely dependent on conditions in these economies, as they accounted for close to 70 percent of global growth (Figure 2.1).
Figure 2.1Distribution of World Output and Growth
Note: Each bar in the upper panel corresponds to the average distribution of world output among country groups in the respective decade (computed using purchasing-power-parity exchange rates). Each bar in the lower panel corresponds to the average of each country group’s contribution to growth in world gross domestic product in the respective decade. The 2000s period includes 2000–12.
With the share of advanced economies in world output down to less than 60 percent over the past 10 years, and their contribution to world growth at about 20 percent, the coincidence between business cycles in advanced economies and global business cycles can no longer be taken for granted. Indeed, in 2007, at the start of the slowdown in economic activity in the United States and other advanced economies, the hope was that emerging market and developing economies would be somewhat insulated from these developments by the size and strength of their domestic demand and the increased importance of trade among themselves.4
At the same time, however, economies are more integrated today through trade and financial flows than in the 1960s, creating greater potential for international spillovers and contagion effects (Figure 2.2). The higher degree of integration increases the feedback, in both directions, between business cycle developments in advanced economies and those in emerging market and developing economies. This raises the odds of more pronounced global business cycles. The implication is that we need a measure of the global business cycle that can account for these evolving changes in the world economy.
Figure 2.2World Trade and Financial Integration
Note: Trade integration is the ratio of total exports and imports to world gross domestic product (GDP). Financial integration is the ratio of total inflows and outflows to world GDP. Each bar corresponds to the average of the indicated measure in the respective decade. The 2000s period includes 2000–12.
Economies are more integrated today through trade and financial flows than in the 1960s, creating greater potential for international spillovers and contagion effects.
Measuring the Global Business Cycle
Our measure of the global business cycle tracks yearly movements in world real GDP per capita. This corresponds to the difference between the weighted rate of growth in real GDP of the large number of countries in our data sample and the rate of growth of their populations. We employ a per capita measure as this takes into account the heterogeneity in population growth rates across countries—in particular, emerging market and developing economies tend to have both faster GDP growth than advanced economies and higher rates of population growth.
Identifying the Turning Points
To determine the turning points of global business cycles, we employ both a statistical and a judgmental method. These are standard methods used for identifying peaks and troughs in national business cycles. The statistical method identifies local maximum and minimum values of the global GDP per capita series over a given period. The method simply implies that a global recession takes place when the growth rate of these series is negative.
The judgmental method follows the spirit of the approach used by the National Bureau of Economic Research to identify recessions in the United States and the Centre for Economic Policy Research in the euro area. We apply this method at the global level by looking at several indicators of global activity: real GDP per capita, industrial production, unemployment, trade and capital flows, and energy consumption.
The two complementary methods provide an intuitively appealing characterization of the turning points in the global business cycle and translate into a concrete definition of a global recession. Specifically, we define a global recession as a contraction in world real GDP per capita accompanied by a broad decline in various other measures of global economic activity. Because we use annual data, a global recession lasts at least one year. Our definition of a global recovery also closely follows the standard definition used in the context of national business cycles. The recovery phase is associated with a broad rebound in activity during the first year following the trough of the global business cycle. In addition, we examine the evolution of global activity in the first three years after a global recession, recognizing that a global recovery can take longer than a year.
A global recession is a contraction in world real GDP per capita accompanied by a broad decline in various other measures of global economic activity.
A Road Map
Here is a brief road map for our journey toward a better understanding of global recessions and recoveries.
In Chapter 3, we introduce our methodology. We construct a comprehensive database that includes a large number of countries and covers 1960–2012 (we extend our sample using forecast values whenever possible). The database allows us to examine fluctuations in the real economy and the financial sector because it includes a wide range of macroeconomic and financial variables. We then present our approach to defining global recession and recovery and discuss the identification of the turning points in the global business cycle. Readers mainly interested in the properties of global recessions and recoveries can skip Chapter 3 and move directly to Part II.
In Chapter 4, we identify the four global recessions since 1960: 1975, 1982, 1991, and 2009. We present a brief narrative of the key events surrounding each episode and analyze the factors that led to a contraction in global GDP per capita.
In Chapters 5 and 6, we document the main features of global recessions and recoveries. In other words, we analyze what really happens during periods of collapse and revival of the world economy. We study the behavior of macroeconomic and financial variables and investigate how the world economy and different groups of countries perform during global recessions and recoveries. We also examine the similarities and differences across the four episodes. The 2009 global recession is particularly interesting as it coincided with the most severe global financial crisis since the Great Depression.5 We focus on how that recession and the ensuing recovery compare with previous episodes. In addition, we analyze the two global downturns (1998 and 2001), during which the world economy slowed significantly but was able to escape an outright recession.
The depth of the 2009 global recession and the sluggish recovery in advanced economies have been topics of intense discussion. In Part III, we analyze the main factors that explain the severity of the 2009 recession and the weak and protracted nature of the recovery. Specifically, we consider the roles of four factors: the highly synchronized nature of the global recession; the severity of financial disruption during 2007–09; the unusually high levels of macroeconomic and policy uncertainty during the recovery; and the surprising divergence of macroeconomic policies and their effectiveness after 2010.
In Chapter 7, we study the extent and implications of the synchronization of national business cycles during global recessions. The 2009 global recession was unique in its unprecedented reach, with almost all advanced economies and a large number of emerging market and developing economies experiencing synchronized contractions in activity. We also analyze how the real economy and financial markets exhibit highly synchronized behavior during global recessions. We then examine the implications of highly synchronized recessions for the depth and duration of these episodes and subsequent recoveries. In addition, we review the literature on the impact of the forces of globalization on the degree of business cycle synchronization.
In Chapter 8, we turn to the more controversial question of how financial crises affect the nature of recessions and recoveries. A number of commentators argue that recessions with financial market problems often lead to larger contractions in output and last longer and that recoveries from such recessions tend to be weaker and slower. In contrast, some others claim that such recoveries are no different than others. We carefully analyze the implications of financial disruptions for the real economy and examine the behavior of a wide range of macroeconomic and financial variables during recessions and recoveries associated with such disruptions. We also summarize the literature on the implications of financial crises for recessions and recoveries.
The role of macroeconomic and policy uncertainty has been in the forefront of many discussions about the nature of the latest recovery. This is easy to understand since the ongoing recovery has seen bouts of elevated uncertainty. In Chapter 9, we study the main features of various measures of uncertainty and their association with growth and business cycles in advanced economies, and we interpret the evidence in light of findings from recent research.
Another major debate since 2008 has revolved around the design and use of fiscal and monetary policies. Unlike during the previous episodes, the response to the latest global recovery has featured substantially different paths for fiscal and monetary policies, mainly in advanced economies. In Chapter 10, we examine how these policies have evolved in different groups of countries. In addition, we summarize the literature on the effectiveness of fiscal and monetary policies in mitigating the adverse effects of recessions.
In Part IV, we turn back to the global business cycle. We study the linkages between the global cycle and national cycles in Chapter 11. These manifested themselves in surprisingly different ways during the 2009 global recession and the ensuing recovery, as growth performance varied significantly across different groups of countries. We examine how the sensitivity of national growth to global growth changes over the global business cycle and varies by country. The chapter also includes a brief discussion of the literature on the channels of business cycle transmission from advanced economies to emerging market and developing economies.
We conclude in Chapter 12 with a summary of lessons from our findings and a discussion of their implications for policy design. We also consider areas for future work that could enrich our understanding of global recessions and recoveries.
Is There a Global Business Cycle?
Several studies offer extensive evidence for cross-country linkages in business cycle fluctuations, strongly supporting the existence of a global business cycle.6 Some of these studies focus on the importance of global, regional, and group- and country-specific factors in accounting for fluctuations in the output, consumption, and investment of a large number of countries.
Global Business Cycles
Global (common) factors explain a significant proportion of business cycle fluctuations over the past 50 years, implying that there is a sizable global business cycle.7 In a recent paper, Hirata, Kose, and Otrok (2013) analyze the importance of global and regional factors in explaining business cycles in a sample of 106 countries, including advanced, emerging market, and other developing economies, during 1960–2010. They report that the global factor accounts on average for 10 percent of the variation in output growth among all countries in their sample. The factor also explains roughly 9 percent of the volatility of the growth rate of consumption and 5 percent of investment. Although the variance shares attributed to the global factor may appear small, they are sizable numbers given that the global factor across the three macroeconomic aggregates is estimated for a very large and diverse set of countries.
The global factor tends to be important in each region, but on average it plays a more dominant role in explaining business cycles in advanced economy regions (North America and Europe), which have stronger intraregional trade and financial linkages than emerging market and developing economy regions (Asia, Latin America and the Caribbean, sub-Saharan Africa, and the Middle East and North Africa). The global factor on average explains about 17 percent of output fluctuations in North America and 27 percent in Europe. In contrast, in the latter group of regions, the global factor explains between 5 percent (in sub-Saharan Africa) and 9 percent (in Asia) of output fluctuations. The global factor is also associated with a substantial share of the variance in consumption and investment growth among the advanced economy regions, accounting on average for about 25 percent and 12 percent of the total variance of these variables, respectively.
Several other studies that examine cross-country correlations also find that business cycles in major advanced economies tend to move together. For example, Hirata and others (2012) report that the average pairwise correlation across advanced economies has been about 0.5 since the mid-1980s, indicating the presence of strong global business cycle linkages. Other studies employing different methodologies reach similar conclusions.8
Regional Business Cycles
Are there regional cycles as well? There has been an explosion of research aimed at better understanding regional cycles. Although the evidence of their existence has been mixed, recent studies report that regional cycles have become increasingly pronounced. In particular, some report that, since the mid-1980s, regional factors have become markedly more important in explaining business cycles, especially in regions that have experienced sharp growth in intraregional trade and financial flows. These patterns are particularly strong in North America, Europe, Oceania, and Asia.9